The two main risk factors in debt mutual funds are interest rate (hyperlink to interest rate risk content) and credit risk. Credit risk of a bond or debenture is the risk of the bond issuer failing to fulfill its interest and / or principal payment obligations, exposing the investor to potential loss of income and / or capital. Government securities (G-Secs) have no credit risk because they come with sovereign guarantee, but corporate bonds or debentures have credit risk.
Credit rating agencies like CRISIL, ICRA etc, assess credit risk of corporate bonds and assign ratings to these securities. The highest rated bonds (AAA rated) have the lowest credit risk, credit risk increases progressively with lower ratings; bonds rated B or lower are high risk investments and bonds rated D are expected to default. Higher the rating of bond, higher is the price and lower is the yield – bonds with lower ratings offer higher yield.
Credit rating of a bond can change over time. If credit rating deteriorates, then price of the bond declines and investors get lower returns. On the other hand, if credit rating improves, then price of the bond rises and investors get higher returns. There are many cases of rating upgrades as there are cases of ratings downgrade; investors should not assume that a lower rated bond will invariably default or that a higher rated bond can never default.
Corporate bond funds and credit risk funds invest primarily in corporate bonds (non convertible debentures) and commercial papers. Investors must make sure that they understand the credit quality profile of the portfolio of these schemes and are comfortable with the credit risk before investing.
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